Money Printing Explains Currency Weakness

We’re all suckers for an elegantly simple explanation and, looking at the weakness of the euro-dollar trading so far this year, the Royal Bank of Scotland came up with a good one.

Forget about better U.S. economic numbers supporting the dollar, or the euro zone’s long debt crisis weighing on the euro, the pair’s weakness was a simple matter of balance sheet expansion at the central banks.

The long-term refinancing operation carried out at the end of 2011 by the European Central Bank wasn’t classic quantitative easing, but it was QE-like enough to have the same effect.

And, over the last 18 months, RBS said, there has been an impressively close correlation between EUR/USD and the ratios of the Federal Reserve’s monetary base to total assets on the ECB’s balance sheet.

Put simply, when the Fed does QE, the dollar goes down; when the ECB does something like it, the euro weakens.

So, all foreign exchange dealers need to do is take a position on the likelihood of any more of the same and trade accordingly.

However, there is a problem with this thesis. You see it wasn’t always thus. When the Fed first unleashed QE back in 2008, the dollar rose and rose. The correlation just wasn’t there.

Back then, as since, the dollar was seen as a haven asset, bought despite all the clouds over its home economy.

However, Commerzbank has another explanation.

Its analysts suggest that the markets used to like extreme monetary policy as shock therapy for capital markets heading for the equivalent of cardiac arrest, but are far less keen on it in its current incarnation as path to more conventional economic goals.

“While in the financial crisis of 2008 an increase of the monetary base was an appropriate tool to inject liquidity into a dysfunctional financial market, such a policy is increasingly inappropriate the more it only aims to target real economic objectives,” they wrote.

This doesn’t mean, then, that we should be blase about the steady trickle of better economic data out of the U.S. By this theory it should, indeed, be supportive of the dollar, but chiefly via the fact that it will make the launch of QE3 much less likely. Euro bulls, meanwhile, should probably prepare for a tough February as it will bring with it the next LTRO from the ECB.